People often think that fund managers are immune to the emotions that afflict ordinary investors, but they aren't. If your fund is run by someone who is overconfident or reacts badly badly when trades go wrong, you may well receive lower returns.
We all know that emotions can be hugely detrimental to investment returns. The study most often used to quantify the so-called behaviour gap between the returns should receive and those they actually receive is Dalbar’s QAIB analysis. The most recent study shows that the average equity fund investor underperformed the S&P 500 by a whopping 5.5% in 2023.
The obvious takeaway from the Dalbar reports is that, instead of bailing out of a fund when performance plummets, or piling in on the back of recent strong returns, you should simply buy and hold for the long run. But although this is generally sound advice, it comes with a caveat. You, the investor, might be rational, patient and disciplined, but how do you know your fund manager is all of those things as well?
Received wisdom is that professional fund managers are more or less immune to the emotions that bedevil amateur traders. Alas, however, it isn’t true, and a recent article in the trade press illustrates this important point very well.
“I’ve punched a wall”
Stuart Rhodes, director of global equities at M&G, and has run the firm’s flagship Global Dividend fund since 2008. Citywire Selector reports that, at a recent M&G event, Rhodes talked candidly about the emotional highs and lows of managing a large active fund.
“I’m not particularly proud of it, but I’ve punched a wall.. and I’ve broken an electrical device at home,” Rhodes apparently told his audience. “It’s not that easy to cope with prolonged periods of underperformance, when you’re behind the market, and you’re just not where the market wants to be.
“It takes over your body, almost takes over your mind. You’re a long way behind, and no matter how many good days you have in the immediate future, it’s still going to be difficult to get back.”
A high-stakes environment
The problem, as analysis like SPIVA shows us time and again, is that most active fund managers underperform most of the time. Why? Because buying and selling the right assets at the right time is extremely difficult. In the long run, only a tiny proportion of managers succeed in beating the appropriate benchmark on a properly cost- and risk-adjusted basis. Poor performance costs managers not just their self-esteem and professional reputations, but also their bonuses and often their jobs. So it’s no surprise that it takes its toll on their emotions.
A well-known study by David Tuckett at UCL and Richard Taffler at the University of Warwick showed how the pressure to deliver strong short-term results creates a high-stress work environment in which fund managers frequently struggle with anxiety, fear and self-doubt. This makes managers develop what Tuckett and Taffler called “emotional coping mechanisms”, engaging in strategies like selective interpretation, performance smoothing, and reinventing investment narratives to manage stress.
So is there evidence that active managers allow their emotions to influence their investment decision-making? Yes, there is. In fact several studies have shown that it’s a real problem.
Picking stocks is “Inherently emotionally arousing”
For example, a 2023 study based on interviews with fund managers in India found that managing an active fund is “an inherently emotionally arousing process”. The managers they interviewed admitted that emotions caused by religious festivals and even sports matches had an impact on their decisions!
Another study that Richard Taffler was involved in showed a direct link between overconfidence in active managers and both the decisions they make and the returns they receive. The researchers analysed the annual reports of active managers for signs of optimism, certainty and self-reference. The most overconfident managers tended to underperform over the next 12 months, with growth-oriented fund managers particularly susceptible.
"Retail investors,” Professor Taffler and his colleague Atman Eshraghi concluded, “are perhaps well advised to stay away from funds whose managers exhibit a high level of overconfidence in their annual reports.”
Lessons for investors
What, then, does all this mean for investors? Well, it’s certainly true that investors need to be aware of their own emotions, such as fear, greed and regret, and ensure they don’t allow those emotions to sway their decisions. This is one way in which a good financial adviser can help.
However, investors should not assume that investment professionals are totally in control of their emotions either. As we’ve seen, active fund management is a high-pressure job. The people who do it may be more emotionally resilient than average, but they’re only human beings and, inevitably, they’re bound to be influenced on occasions by their feelings.
If you want to eradicate emotions from the investment process altogether, your best option is to invest in a diversified portfolio of index funds and set it to rebalance automatically.
Think about it. Would you rather entrust your portfolio to the collective wisdom of millions of market participants around the world, including all the smartest analysts and money managers? Or to a single, fallible stockpicker who’s prone to punching holes in the wall when another trade goes wrong?
I know which I would rather put my faith in.
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